Chapter A: Personal taxation

A1. Personal income tax

Personal income tax is Australia's single biggest source of taxation revenue, raising 37 per cent of total tax revenue. It should raise revenue simply and transparently from a relatively efficient tax base, while maintaining incentives to work and save. Personal income tax also plays a central role in achieving a progressive tax system by raising proportionally more revenue from those who have a greater capacity to pay.

Most adult Australians are affected by the personal income tax system every year, with around 12 million people filing tax returns annually.

As a proportion of GDP, revenue from personal income tax has fallen over the past two decades, with a series of tax cuts a major contributor in the last decade. In the future, demographic change will impact on growth in personal income tax revenue because a greater proportion of the population will be in retirement. If rising debt and reductions in government services are to be avoided, action will be needed to increase the amount of revenue raised from this or other tax bases.

The share of personal income tax in Australia, at 37 per cent of total tax revenue, is high compared to the OECD average of 25 per cent. Much of this difference is explained by the fact that Australia does not levy additional social security taxes in the way that most other OECD countries do (with benefits based on a person's previous earnings), at an average rate of 25 per cent of total tax revenue. Instead, Australia funds social security payments from general government revenues, and has a compulsory superannuation guarantee (that is, excluded from the calculation). Taking this into account, Australia's total taxation on personal income is among the lowest in the OECD, at 41 per cent compared to an OECD average of 51 per cent.1

The tax system has a close relationship with the transfer payment system, given the large number of people who are in both systems at any given time. The two systems have different objectives, with the tax system focused on capacity to pay and the transfer system on need. The Review has considered in some depth the extent to which key structural elements of the two systems might be aligned, such as the definition of income and the unit and period of assessment. It has concluded that full integration of the two systems is neither achievable nor desirable because of the differences in their purposes, although policy in the two systems should always be developed jointly and service delivery should be coordinated.

Fairness should continue to be a key principle in the design of the personal income tax system. For the community to be willing to comply with the tax law, people need to be confident that their liability is assessed fairly and reflects their ability to pay. There is strong and widespread support for the proposition that proportionally more revenue should be raised from those with a greater ability to pay. While there are many ways to reach such outcomes, it is important they be achieved in as simple and transparent a way as possible. In addition, a personal income tax system to suit an ageing population needs to be structured to reduce disincentives to work for the smaller proportion of the population who are of working age and to increase incentives for people to save and invest for their future.

Principles

The personal income tax system should raise revenue fairly — in terms of both the income on which tax is levied (the tax base) and the rates that apply — and contribute to achieving the government's redistribution goals.

Revenue-raising through the personal income tax system should operate as simply and transparently as possible.

Revenue-raising through the personal income tax system should avoid discouraging work and saving as far as possible.

A fair personal income tax system

The fairness of personal income tax is fundamental as an expression of societal values and is a prerequisite for people to be committed to the system and prepared to meet their obligations. There are two core elements to a fair system — a progressive tax rate structure and an appropriate definition of income.

The current personal income tax system seeks to aggregate income from both work and savings to form a single measure of taxable income. In practice the major part of household savings, including owner-occupied housing and superannuation, is exempt or effectively exempt. In designing the personal income tax system, labour income and the income from savings should be considered as separate though interconnected elements.

Income from work is currently taxed in different ways, depending on the nature of the worker's employment or their remuneration. While most people with work income have either salary and wage income or business income, which are taxed similarly, many people take some of their remuneration in the form of superannuation or fringe benefits, both of which have completely separate taxation arrangements. Some people's income from work is entirely exempt from tax. The costs associated with earning income are also treated inconsistently. A tax system for the future would tax wages and fringe benefits in a similar way, and also tax compulsory superannuation contributions with reference to a progressive personal income tax rates scale.

Income from savings, other than lifetime savings, is also taxed in a wide variety of ways. Varying arrangements apply to interest-bearing deposits, income from domestic shares, income from foreign shares, and rents from residential properties. A tax system for the future would tax these different forms of investment as consistently as possible, and also take account of the way inflation affects the effective tax rate on savings. It could do so by providing a common discount for a range of savings income or by applying a flat rate of tax to that income. Long-term, lifetime savings in the form of superannuation and owner-occupied housing should continue to be effectively exempt from income tax.

Personal income tax is calculated by applying a marginal rates scale to a person's combined income from work and savings. The progressive personal income tax rates scale is a strength of the system that should be retained. At present, the great majority of tax revenue comes from higher income earners. In 2007–08, the 16 per cent of taxpayers on more than $75,000 accounted for 55 per cent of personal income tax revenue, with almost half of that coming from the three per cent of taxpayers with taxable income over $150,000.

A progressive system can be achieved in various ways. At present, Australia has a relatively low tax-free threshold and four marginal rates above it, along with a large number of tax offsets that alter the marginal rates for people in particular situations. The direction of change has been towards fewer marginal tax rates, from as many as six or seven during much of the 1980s and early 1990s. An alternative way of delivering a progressive personal income tax rates scale would be through a much higher tax-free threshold and a flat or rising rate scale. This would make the system easier to understand by removing the need for a number of tax offsets. By taking more income support recipients out of the tax system, it could also reduce the number of people who have to deal with both systems at the same time.

Chart A1–1 shows such a tax scale, with progressivity delivered through a large tax-free threshold and a constant marginal tax rate of 35 per cent for most taxpayers.

Chart A1–1: Indicative personal income tax rates scale

A simple scale with a high tax-free threshold

Source: Treasury estimates.

A simple and transparent system

Many people find the personal income tax system complex, not only because of the rates scale and the lack of a coherent definition of taxable income, but also because they must deal with a large set of complex deduction rules, numerous tax offsets and different forms of exempt income.

A consequence of this is that the system is not transparent to taxpayers. It can be difficult for taxpayers to have a sense of their taxable income because of the complex rules associated with deductions, which are claimed by 80 per cent of personal income taxfilers. A common response to this and other forms of complexity in the tax system is to seek advice from a tax agent. Around three quarters of taxfilers seek such assistance. Nonetheless, in 2007–08, 86 per cent either claimed no deductions at all or only claimed work-related expenses, gifts and the costs of managing tax affairs. This suggests that the system is too complex and the compliance burden too high.

Australia's use of tax agents is high by international standards; only Italy's is higher. By contrast, the Nordic countries, which have pre-filling arrangements for tax returns, have very low levels of tax agent use (see Chart A1–2). To simplify people's interactions with the tax system and facilitate much greater levels of pre-filling of tax returns, an automatic standard deduction should be introduced. However, to ensure that individuals with more complex affairs or high expenses are not disadvantaged, taxpayers would still have the option of substantiating a claim for all eligible expenses.

Chart A1–2: Percentage of taxfilers using a tax agent, 2005

Source: OECD (2005).

A more transparent system would improve people's ability to understand their tax rate and to predict the impact of changes in their work or savings arrangements. A key way of achieving this would be to incorporate some offsets into the personal income tax rates scale, and to limit non-structural offsets to situations where they meet an ongoing need that cannot be met in a more targeted way. The transparency of the system would also be improved by a more complete separation of the tax system from the transfer system. This could be achieved by setting the tax-free threshold at a much higher level for all taxpayers.

Longer term reforms should be made with a view to creating a simpler and more transparent system. Policy changes should support simplification by facilitating fully automated preparation of tax returns. Using information that is reported by a third party such as an employer or financial institution is an important part of this, rather than relying on information that has to be collected by the taxpayer over the course of the tax year. People of retirement age could be given the option of submitting their details on a single form with their partner, thus reducing the compliance burden where they own assets jointly. While it would be more complex, joint assessment could be considered for couples of late retirement age. Policy changes should also support transparency so that people can understand the incentives they face to work and save, and are better able to predict the impact of a change to their work or personal circumstances.

A system designed to reduce disincentives to work and save

The way that personal income tax is levied can make a significant difference to how much people work and save. Incentives to work and save are influenced by the effective tax rates that individuals face. Some people's effective rate is entirely determined by the personal income tax rates scale; although, for most adults, withdrawal rates on transfer payments and additional tax provisions also contribute to their effective tax rate.

A tax system for the future needs to take account of changes in the population, and particularly the relative size of the working age and retired populations. Over the next 40 years, the retirement age population is expected to grow faster than the working age population. By 2049, over one fifth of the population is projected to be aged 65 and over, compared to 13 per cent in 2009 (see Chart A1–3). While workforce participation rates are high now compared to rates in the past, maintaining high rates in future will require a tax and transfer system that supports and encourages work. Without high participation rates, the scope to fund payments and services for older Australians and to invest in younger generations will be compromised.

Chart A1–3: Proportion of the population aged 65 and over

Source: Treasury projections.

Incentives to work matter, not only because of the importance of personal income tax to total revenue collections, but also because people make important saving and investment contributions during the working phase of their lives. A tax system that supports work and saving must provide worthwhile returns to these activities, for those people already in work or looking for work, and potentially also for people who may not traditionally have sought employment, if they wish to work.

Returns from working influence people in different ways. A large body of theory and empirical studies has shed light on how tax policy can best respond to these differences. People who are relatively unresponsive to effective tax rates or financial incentives include men and women in their main working years without dependent children. These groups do not typically change their work effort in response to a higher marginal tax rate. Others, however, may withdraw from work altogether if faced with a high effective tax rate. These groups include women with an employed partner and those people who receive a non-activity-tested income support payment.

The capacity of the tax system to respond to these different behaviours is limited, but it does affect incentives for people who do not receive transfer payments and it interacts with transfer payments for people who may do some work now or in the future. At present, the tax system adapts to accommodate the transfer system, by removing maximum-rate full-year income support recipients from the requirement to pay tax. It does this by providing tax offsets for income support recipients with little or no private income. A more transparent system would reverse this arrangement, with the same tax rules applying to everyone and the transfer system adapting to the tax rules. This could be achieved by exempting income support and other transfer payments from tax entirely. In addition, withdrawal rates on payments could be reduced once an individual's income was high enough to produce a tax liability, to cap the overall effective marginal tax rate. The benefit of these changes would be more transparent effective tax rates.

While the proportion of Australians who participate in the workforce is high by international standards (76 per cent of the working age population compared to an OECD average of 71 per cent), this is partly due to Australia having the highest labour participation rate for students in the OECD. After making adjustments to account for measurement differences, the Productivity Commission found that the participation rate of Australian men aged 25 to 54 is below the OECD average. Australian women in the same age group have participation rates above the OECD average, but still curtail their engagement in the workforce during the typical child-bearing years more than is the case in New Zealand, the United Kingdom and the United States (Chart A1–4).

Chart A1–4: Female participation rates, by age, 2008

Source: OECD(2008b).

Lower participation rates for women of child-bearing age are also reflected in employment rates. The employment rate for women with a youngest child aged between three and five years is below the average for all OECD countries that collect this data, and is 25 percentage points below the Swedish rate (ABS 2007a).

This suggests that women of child bearing age constitute one of the key groups with greater potential for paid employment. Many of these women are caring for children, and prefer to take a period out of employment while they do so. Many seek employment, but do not always have access to satisfactory child care. The longer the period out of the workforce, the greater the risk of skills atrophying and poorer employment opportunities later on. While there are many factors at play, financial incentives cannot be ignored. One of the most effective ways to improve financial incentives for people with dependent children is to set effective tax rates that support part-time work and recognise that carers in couple families are likely to have lower earnings than their partner. Taxing people as individuals is important in terms of financial incentives, because it applies a different tax rate to each partner in a couple rather than both people facing a pooled tax rate.

For non-lifetime savings, the current tax system's inconsistent treatment of different types of saving not only affects the level of savings but can also affect how households allocate their savings between different assets or savings vehicles. A future tax system would reduce these biases by taxing different types of saving more consistently.

The remainder of this section discusses core elements of the personal income tax system (see Chart A1–5) in more detail:

1 Total taxation on personal income includes personal income tax, social security tax and payroll tax. It does not include Australia's compulsory superannuation guarantee, as this is not currently classified as a tax.